What is key person insurance and does your business need it?
What is key person insurance and does your business need it?
Key person insurance is a policy a business takes out on the life of someone it depends on, so that the business receives a lump sum if that person dies or, where the cover includes it, is diagnosed with one of the serious illnesses the policy covers.
Whether your business needs it depends on how much of its income, its borrowing or its customer relationships rest on one or two people, and on whether it could absorb the loss of one of them from its own reserves. A large employer can usually do that, whereas a small or owner-managed company often cannot, at least not for long.
In a hurry?
Key person insurance pays your business a lump sum if someone it depends on dies or, where the cover includes it, is diagnosed with one of the serious illnesses the policy covers. This article explains who counts as a key person, how much cover a business needs, how the premiums and payouts are taxed, and how to judge whether your business needs it at all.
Speak to a specialist adviser →Most business owners would not think of leaving their premises, vehicles or stock uninsured. A fire or a theft is easy to picture and easy to put a price on. However, the loss of the person who wins most of the work, or the only one who really understands the systems, is harder to imagine and much harder to value, which is why it tends to be left for another day.
It is worth remembering that a business is rarely tested at a convenient moment. If a key person died or became seriously ill, the business would be dealing with the loss of a colleague, and often a friend, while its customers, its lenders and its staff were all asking what happens next. Money does not replace the person, but it gives the people left behind time to make considered decisions rather than hurried ones.
Business protection comes in two main forms, and the two are easily confused. Key person cover pays the business itself so that it can keep trading. Shareholder protection, by contrast, gives the surviving owners the money to buy a deceased owner’s shares, and it is the subject of our article on what happens to a business if one of its shareholders dies.
This article explains how key person insurance works and how to judge whether your business needs it:
Who counts as a key person in a business?
A key person is anyone whose death or serious illness would cause your business a real financial loss, and although that person is often an owner or a director, it does not have to be. It could equally be the sales director who holds the relationships with your largest customers, the engineer whose knowledge is not written down anywhere, or the person whose name and reputation bring the work in.
A useful way to identify a key person is to think through what would happen if they were suddenly not there. The questions that matter are how long it would take to replace them, what it would cost, and whether your customers, your suppliers and your lenders would stay as confident in the business as they are now.
Insurers apply a similar test, because a business can generally only insure someone if it stands to lose money by losing them. An insurer will therefore want evidence of what that person is worth to the business, and the person themselves has to agree to the cover and answer the medical questions.
In a very small business the key person is often the owner, and how the cover is arranged then depends on the legal form of the business. A limited company or a limited liability partnership can own a policy itself. Sole traders, and traditional partnerships outside Scotland, are not separate legal entities, so the cover is usually set up personally and placed in trust for the partners or for the family.
How does key person insurance pay out?
Key person insurance pays out to whoever owns the policy, which in a limited company is the company itself rather than the insured person or their family. The company applies for the policy, pays the premiums and receives the money, which is why you will sometimes see it described as a ‘life of another’ policy.
The policy usually runs for a fixed term and pays a lump sum if the key person dies during that term. Cover can often be extended to include critical illness, which pays out if the person is diagnosed with one of the serious conditions the insurer lists and meets the policy’s definition of it. This extension matters because a serious illness can keep someone away from the business for a year or longer, and the effect on the business can be much the same as if they had died.
Unless the policy has been assigned to a lender, the business can generally use the money as it sees fit. It might replace lost profit while trading recovers, pay to recruit and train a replacement, repay a loan or simply reassure customers and staff that the business has the means to carry on.
It is worth stating the obvious that a policy only does its job if it is kept up to date. Cover on a director who left the business some years ago serves little purpose, and a business that has grown substantially since its cover was arranged is probably underinsured.
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Join our readers →How much key person cover does a business need?
The amount of key person cover a business needs is essentially whatever it would cost to get through a period without the named person, and there is no single formula for working that out. Insurers and advisers generally start from one of a few figures: a multiple of the profit the key person is responsible for, a multiple of their earnings, the time and cost involved in recruiting and training a replacement, or the amount of any borrowing that would have to be repaid.
None of these methods is exact, because the contribution one person makes to a business is hard to separate from everybody else’s. The profit-based methods suit a salesperson or a fee earner whose income can be traced, and they work less well for a finance director or an operations manager, whose contribution is real but does not appear on any one line of the accounts.
However, an insurer is unlikely to simply accept the figure a business asks for, and for larger amounts it will usually want financial evidence, such as the accounts and an explanation of how the amount was reached. It will also be reluctant to insure someone for much more than the loss it can calculate. Equally, the cover should not run for longer than the person is likely to remain important to the business, which usually means a fixed term of years, rather than cover for the whole of their life.
It is important to remember that where a director has personally guaranteed a business loan, the lender can usually turn to that director, and in many cases to their estate, if the business cannot repay, so the guarantee absolutely belongs in the calculation. Tax matters too, because if the payout is likely to be taxed in the hands of the business, the cover may need to be set higher to leave the amount the business actually needs.
Is key person insurance tax deductible?
The tax treatment of key person insurance depends on what the policy is intended to protect and who is insured. It is not determined simply by the type of policy you buy.
There are two separate tax questions to consider:
Can the business deduct the premiums from its taxable profits?
Will any payout be taxable when the policy pays out?
These questions are related, but the answer to one does not automatically determine the answer to the other.
When are key person insurance premiums tax deductible?
HMRC’s guidance sets out when premiums can be treated as a deductible business expense. Broadly, the cover needs to meet two conditions:
Its sole purpose must be to replace trading income the business is likely to lose if the key person dies or becomes seriously ill; and
If the policy is a life policy, it must generally be plain term assurance and last no longer than the period for which the person is expected to be useful to the business.
Where these conditions are met, the premiums will normally be deductible from the business’s taxable profits.
This means the policy is effectively protecting the business against a loss of trading income, rather than protecting an asset or the value of the business itself.
When might premiums not be deductible?
The premiums may not qualify for tax relief where the policy is intended to protect something other than the business’s trading income.
For example, this can arise where the insured person is both a director and a major shareholder. HMRC may consider that the policy protects the value of their shares as well as the trading income of the business.
The same issue can arise where key person cover is arranged to repay a business loan. In this situation, the policy is protecting the business’s capital position rather than replacing trading income.
In these circumstances, the premiums may not be deductible.
Is a key person insurance payout taxable?
The tax treatment of the payout is a separate question.
Where premiums have been treated as a deductible business expense and the policy meets HMRC’s conditions, a payout will generally be treated as trading income and taxed as part of the business’s profits.
Where the premiums were not deductible (for example, because the policy was intended to repay a loan), the payout may not be taxable as trading income. However, this does not follow automatically. The treatment of the premiums and the treatment of the payout must be considered separately.
For this reason, businesses should not assume that a payout is tax-free simply because the premiums were not deductible.
Should you check the tax treatment with HMRC?
Because the tax treatment depends on the purpose of the cover and the circumstances of the business, it can be sensible to ask HMRC for its view before arranging the policy, usually through your accountant.
However, HMRC may not provide a binding decision on the tax treatment of a particular policy.
Where a business needs cover both to replace lost trading income and to repay a loan, these are often arranged as separate policies, because they have different tax implications.
What about sole traders and partnerships?
Sole traders and partners are treated differently again. Tax relief on premiums is not normally available where the person insured is an owner of the business rather than an employee.
The tax rules can be complex and depend on the specific circumstances of the business. Your accountant and insurance adviser should therefore consider the tax treatment together when deciding what cover to arrange.
Does your business need key person insurance?
Your business may well need key person insurance if its profits, its borrowing or its most important relationships depend on one or two people, and it does not hold enough cash to get through a year or two without one of them. That description fits many owner-managed companies, professional practices and family businesses, and it is especially likely to fit a business in its early years.
The need is weaker where the work is spread widely, where nobody’s departure would cost the business a customer, or where it has reserves it could draw on instead. A larger company with several layers of management and cash in the bank may reasonably decide to carry the risk itself. Insurance is also only one answer to the problem, and it sits alongside the more ordinary jobs we often never get around to: writing processes down, sharing the important client relationships and bringing on a deputy.
Sometimes, however, the decision to take out key person insurance is made for you, because a lender may make cover a condition of a loan, and an investor may insist on it before putting money into a business that depends on its founder.
The cost depends on the age and health of the person insured, whether they smoke, the amount of cover, the length of the term and whether critical illness is included. Life cover on its own is generally the cheaper part, and adding critical illness cover increases the premium.
An easy practical test is to try to name the person the business could least afford to lose and estimate what losing them would cost. If the business could not meet that cost from its own resources, there is a good case for looking at cover, and if nobody comes to mind or the cost would be manageable, cover may not be needed at all.
Does your business depend on one or two people?
Our Chartered Financial Planners advise business owners on key person insurance and shareholder protection, from working out the level of cover to how the policy is set up. Find out how we work with clients across the UK.
Business protection insurance →What's next?
Key person insurance is straightforward in principle, but the details decide whether it works when it is needed: who is insured, for how much, for how long and for what purpose. Those choices affect what an insurer will offer and how the premiums and any payout are taxed, so they are worth settling properly at the outset.
Our Chartered Financial Advisers offer a free initial consultation to anyone who wants to review the protection their business has in place or find out what key person cover would involve.
We work with clients across the UK. Locally, we advise clients throughout Kent and East Sussex, including Tunbridge Wells, Sevenoaks, Maidstone, Tonbridge, Crowborough and Eastbourne.
This article is for general information only and does not constitute personal financial advice or a recommendation. The suitability of any protection or financial arrangement depends on individual circumstances, objectives and the current regulatory environment. Tax treatment and related rules can change over time, and their effect will depend on personal circumstances.
